If 2013 was the year postcrisis financial regulations
transformed the hedge fund industrys strategic landscape,
2014 may see this trend go a step farther as the gulf widens
between managers who can succeed in the new environment and
those who cannot. The biggest risk many funds face is
strategic: the need to grow assets under management to support
margins that have been under pressure from rising operational
and compliance costs and investor complaints about fees.

Apart from this operational risk, there are two market risks
that could cause managers headaches in 2014. First, the
stepwise withdrawal of the Federal Reserves quantitative
easing program, or other events the markets find unsettling,
could trigger a rise in equity correlations and a fall in
dispersion, reversing trends that made 2013 a profitable year
for long-short and other equity strategies. Whereas the
Feds December 18 announcement to taper QE did not meet
with this type of reaction, talk of a taper back in June
did.

The worst-case scenario would be a return to the high-risk
environment of 2010, 2011 and part of 2012, when there were
huge and costly correlation spikes, says Sebastián
Ceria, CEO of New Yorkbased buyside risk analysis firm
Axioma. Things went well this year because hedge
funds ability to control risk has been facilitated by the
fact that correlations have come down significantly, he
says. Axioma, he adds, is currently concerned about what it
calls the correlation roller coaster. When [correlation]
spikes, it spikes in a hurry, he says.

Second, the reduction in bank proprietary trading
mandated by the Volcker Rule could affect liquidity in
thinly traded markets, causing prices to rise and generating
losses for some
hedge funds. The banks argued that the markets would
suffer if prop trading went away, back when they were lobbying
against Volcker, says the chief risk officer of a New
York multistrategy fund management company, who asked not to be
named. That could be, but its a hard risk to
quantify at this point.

By contrast, the regulatory risk faced by small and
medium-size
hedge funds is already having an effect, causing them to
urgently attempt to boost assets under management (AUM).

An annual survey of hedge fund managers and investors by
Ernst & Young, conducted in July and August 2013, found
that growth was the top strategic priority for more than two
thirds of participating managers.

Weve seen the cost of business go up
significantly, and in order to survive and grow their margins,
hedge funds have been looking for different ways to
grow, says Ernst & Young partner Natalie Deak Jaros,
a member of the firms global hedge fund practice. The
rollout of registered funds under the Investment Company Act of
1940 with low fees and minimums; low-fee, long-only products;
and private equity vehicles is an example of attempts by hedge
fund managers to tap new sources of investor demand.

This scramble for assets favors large firms. It brings
a whole host of risks, such as additional regulatory scrutiny
and operational risk, she says. Investments in personnel,
technology and other infrastructure needed to manage greater
AUM are scalable, so funds large enough to develop and sell
many of these products can make the investment pay off. These
tend to be funds with at least $10 billion in assets, she
says.

The problem is particularly acute for start-ups. The
barriers to entry in terms of setup operational costs 
onshore regulatory, compliance, due diligence, systems
requirements, personnel and other infrastructure costs 
are only going to grow, says Ian Gobin, partner and
global head of the funds and investment services practice at
law firm Appleby in the Cayman Islands. And for a
start-up hedge fund manager, this is problematic.

Small funds are also at a disadvantage in the pursuit of
institutional money, as investors
increasingly prefer large funds with best-in-class compliance
infrastructure. If you intend to attract institutional
money, a manager needs a meaningful front-and-back office
operation and a strong track record, Gobin says.
And even so, a lot of new
hedge funds get stuck around the $50 million assets under
management mark. Institutional investors
tell them to come back when they reach $100 million or more,
but they cant get there without institutional
money.

One development that could help small funds build up their
assets is the Securities and Exchange Commissions
new regulations permitting general solicitation of
investors, mandated by the Jumpstart Our Business Startups
(JOBS) Act of 2012. The change in the rules on general
solicitation is the biggest development in fundraising in a
long time, says Jeffrey Blomberg, a partner at law firm
Withers Bergman in Greenwich, Connecticut, who advises funds
and institutions on private investment transactions. Whereas
funds will have to provide more information to the SEC, they
could see the greater scrutiny as a fair trade-off for the
ability to advertise and solicit a wide range of potential
investors.

The final SEC general solicitation regulations are not yet
out, but if they do facilitate growth by smaller funds, they
could also reduce the risk of extinction for them. That could
be a good thing. The biggest risk for the U.S. hedge fund
market as a whole is the loss of the start-up entrepreneurial
hedge fund manager, Gobin says. If that happens, he adds,
where will investors get their best returns?